Question

A gas station owner sees a report on TV which states that the number of gallons of gasoline sold in the U.S. has barely dropped, even as the price per gallon has soared in recent weeks. The price elasticity of demand for gasoline is described in the report as “highly inelastic”. The gas station owner responds to this report by jacking up the prices at his station by 50 cents per gallon. Sales and revenues at his station plummet in the first month after the price increase and drop even further in the second month. What factors did this gas station owner fail to consider when he responded to the TV report by aggressively raising his prices?

Answer 1

Answer:

A gas station owner sees a report on TV which states that the number of gallons of gasoline sold in the U.S. has barely dropped, even as the price per gallon has soared in recent weeks.

The news indicates that the number of gallons of gasoline sold in the U.S. has barely dropped, even as the price per gallon has soared in recent weeks.

This means the % fall in the quantity demanded for gasoline sold is quite less and the % rise in the price of gasoline has been quite higher. We interpret the price elasticity of demand for any product as the ratio of

ed = % change in QD/ % change in price.

Now the news says that gasoline is “highly inelastic”. This is correct because demand is inelastic (value of ed is less than one) when % change in QD is less than the % change in price. Here we have already said that % fall in the quantity demanded for gasoline sold is quite less and the % rise in the price of gasoline has been quite higher. Hence demand for gasoline is inelastic

The gas station owner responds (to the best of his knowledge) by increasing the prices at his station by 50 cents per gallon. Now his knowledge of economics has so far been correct because when demand is inelastic, prices can be increased because quantity demanded will fall only slightly and so revenues are expected to rise.

Much to his surprise, the sales and revenues at his station plummet in the first month after the price increase, and drop even further in the second month. This does not seem strange because the owner failed to consider one important aspect. Though gasoline has inelastic overall demand, its demand within a region is highly elastic because there are several other sellers of gasoline. So the rule he forgot to implement was

The demand for a narrowly defined good (gasoline within an area) is elastic but for a broadly defined good (gasoline for the entire nation) is inelastic
Hence, if all the gas stations increase their prices, then somehow the demand will become inelastic and he can expect revenue to rise.